International Diversification: Is It Worth It?

1

International Diversification: Is It Worth It?

Claude B. Erb Campbell R. Harvey Tadas E. ViskantaTCW, Duke University, Independent,Los Angeles, CA USA Durham, NC USA Chicago, IL USA NBER, Cambridge, MA USA

Sanford C. Bernstein & Co., LLCControversies in Quantitative Finance and Asset Management | 2005

March 1, 2005 Pierre Hotel, New York

2

3

Targeting The “Risk” of the MSCI World IndexDecember 1969 to January 2005

Asset Allocation Analysis Zephyr AllocationADVISOR: Trust Company of the West

Efficient FrontierReturn vs. Risk (Standard Deviation)

13 14 15 16 17 18 19 20 21 22 23 2410.5

11.0

11.5

12.0

12.5

13.0

Risk (Standard Deviation)

Ret

urn MSCI EAFE

MSCI EUROPEMSCI PACIFIC

MSCI THE WORLD INDEX

MSCI USA

Asset Allocations - Active PortfolioPercent of Portfolio

30.0%

48.9%

21.1%

MSCI EAFEMSCI EUROPEMSCI PACIFICMSCI THE WORLD INDEXMSCI USA

Portfolio Return: 12.17%Portfolio Standard Deviation: 14.52%

Tracking to Benchmark - Active PortfolioMSCI THE WORLD INDEX

6.6%

93.4%

R-Squared ResidualTracking Error: 3.76%

• The “optimal” portfolio is largely “foreign”

4

Targeting The “Risk” of the MSCI World IndexDecember 1987 to January 2005

• The “optimal” portfolio is largely domesticAsset Allocation Analysis Zephyr AllocationADVISOR: Trust Company of the West


12 14 16 18 20 22 24 26 282

4

6

8

10

12

14

16

18


Ret

urn

MSCI EAFE

MSCI EUROPE

MSCI PACIFIC


MSCI USA

MSCI EM (EMERGING MA


12.5%21.2%

66.3%

MSCI EAFEMSCI EUROPEMSCI PACIFICMSCI THE WORLD INDEXMSCI USAMSCI EM (EMERGING MA


Tracking to Benchmark - Active PortfolioMSCI THE WORLD INDEX

21.9%

78.1%


5

Targeting The “Risk” Of The MSCI U.S. IndexDecember 1969 to January 2005

• The “optimal” portfolio has little U.S. exposure



13 14 15 16 17 18 19 20 21 22 23 2410.5

11.0

11.5

12.0

12.5

13.0


Ret

urn MSCI EAFE

MSCI EUROPEMSCI PACIFIC


MSCI USA


9.0%

23.2%

67.8%

MSCI EAFEMSCI EUROPEMSCI PACIFICMSCI THE WORLD INDEXMSCI USA


Tracking to Benchmark - Active PortfolioS&P 500

45.8%54.2%


6

Targeting The “Risk” Of The MSCI U.S. IndexDecember 1987 to January 2005

• The “optimal” portfolio has little “foreign” exposure



12 14 16 18 20 22 24 26 282

4

6

8

10

12

14

16

18


Ret

urn

MSCI EAFE

MSCI EUROPE

MSCI PACIFIC


MSCI USA

MSCI EM (EMERGING MA


12.5%21.2%

66.3%

MSCI EAFEMSCI EUROPEMSCI PACIFICMSCI THE WORLD INDEXMSCI USAMSCI EM (EMERGING MA


Tracking to Benchmark - Active PortfolioS&P 500

9.5%

90.5%


7

International Diversification – Is It Worth It?

Interesting question but …

what question is being asked?

• It is possible to parse this into at least four questions

– Does passive investment outside of your home market increase return?

– Does active investment outside of your home market increase return?

– Does passive investment outside of your home market reduce risk?

– Does active investment outside of your home market reduce risk?

• Let’s take a look at some answers

8

US Domestic Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005

$1

$6

$11

$16

$21

$26

$31

$36

$41

$46

$51

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

198219

8319

8419

8519

8619

8719

8819

8919

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

04

Gro

wth

of $

1

MSCI USA MSCI WORLD ex USA

Data Source: Morgan Stanley Capital International

• A U.S. investor might look at historical performance and wonder– Why invest in non-US equities?

9

The Allure Of Tactical AllocationU.S. Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005

0%

5%

10%

15%

20%

25%

30%

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

US/

Non

-US

Trac

king

Erro

r


• A declining “domestic/foreign” tracking error suggests a reduced opportunity to add value from tactical allocation– Excess Return = Excess Return Ratio * Tracking Error

10

European Domestic Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005

$1

$11

$21

$31

$41

$51

$61

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Gro

wth

of $

1

MSCI Europe MSCI World Ex Europe


• A European investor might look at historical performance and wonder– Why invest in non-European equities?

11

The Allure Of Tactical AllocationEuropean Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005

0%

5%

10%

15%

20%

25%

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Eur

opea

n/N

on-E

urop

ean

Tra

ckin

g E

rror


• A declining “domestic/foreign” tracking error suggests a reduced opportunity to add value from tactical allocation

12

U.K. Domestic Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005

$1

$11

$21

$31

$41

$51

$61

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Gro

wth

of $

1

MSCI United Kingdom MSCI World Ex UK


• A U.K. investor might look at historical performance and wonder– Why invest in non-UK equities?

13

The Allure Of Tactical AllocationU.K. Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005

0%

10%

20%

30%

40%

50%

60%

70%

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

U.K

./Non

-U.K

. Tra

ckin

g E

rror


• A declining “domestic/foreign” tracking error suggests a reduced opportunity to add value from tactical allocation

14

Japanese Versus Foreign PerspectiveGrowth of $1December 1969 to January 2005

$1

$11

$21

$31

$41

$51

$61

$71

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Gro

wth

of $

1

MSCI JAPAN MSCI World Ex-Japan


• Even a Japanese investor might look at historical performance and wonder– Why invest in non-Japanese equities?

15

The Allure Of Tactical AllocationJapanese Domestic/Foreign Tactical Asset AllocationDecember 1969 to January 2005

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Japa

n/N

on-J

apan

Tra

ckin

g E

rror


• A stable “domestic/foreign” tracking error suggests an unchanged opportunity to add value from tactical allocation

16

Maybe Sectors More Important Than Countries?

Annualized S&P 500 Tracking ErrorMSCI WRLD/ENERGY 14.94 MSCI AUSTRALIA 13.77MSCI WRLD/MATERIALS 13.36 MSCI AUSTRIA 19.04MSCI WRLD/INDUSTRIALS 8.01 MSCI BELGIUM 18.30MSCI WRLD/COMML SVC & SUPPL 10.29 MSCI CANADA 12.21MSCI WRLD/TRANSPORTATION 12.20 MSCI DENMARK 12.97MSCI WRLD/CONS DUR & APPAREL 14.04 MSCI EM (EMERGING MARKETS) 13.92MSCI WRLD/CONSUMER STAPLES 17.18 MSCI FRANCE 12.75MSCI WRLD/HEALTH CARE 16.07 MSCI GERMANY 17.84MSCI WRLD/FINANCIALS 9.54 MSCI HONG KONG 17.90MSCI WRLD/IT SVC 24.89 MSCI ITALY 16.97MSCI WRLD/TELECOM SVC 17.01 MSCI JAPAN 17.92MSCI WRLD/UTILITIES 16.09 MSCI NETHERLANDS 13.07

MSCI NORWAY 14.34MSCI SPAIN 15.24MSCI SWEDEN 22.44MSCI SWITZERLAND 13.74MSCI UNITED KINGDOM 9.07

Average 14.47 15.38

17

The Minimum Variance Portfolio Over Time

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

US Portfolio Exposure Average

Rolling 12-month optimization.

18

Rolling Ten Year Total ReturnsDecember 1969 to January 2005

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Rol

ling

Ten

Yea

r T

otal

Ret

urns

MSCI PACIFIC MSCI EUROPE MSCI JAPAN MSCI USA MSCI THE WORLD INDEX


MSCI PACIFIC MSCI EUROPE MSCI JAPAN MSCI USAReturn > MSCI World 60.60% 72.52% 60.93% 46.69%

19

Does passive investment outside of your home market reduce risk? Rolling Ten Year Standard Deviations Of Return ReturnsDecember 1969 to January 2005

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Rol

ling

Ten

Yea

r St

anda

rd D

evia

tion



MSCI PACIFIC MSCI EUROPE MSCI JAPAN MSCI USARisk > MSCI World 100.00% 100.00% 100.00% 75.17%

20

Does passive investment outside of your home market reduce risk?Rolling Ten Year Sharpe RatiosDecember 1969 to January 2005

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Rol

ling

Ten

Yea

r Sh

arpe

Rat

io



MSCI PACIFIC MSCI EUROPE MSCI JAPAN MSCI USASharpe Ratio > MSCI World 41.06% 64.57% 43.38% 43.71%

21


While the U.S. is a smaller part of world market capitalization, correlations are high.

• We consider some alternative ways of considering correlation– Average returns based on U.S. up and down markets– Average returns based on quintiles of U.S. returns– Average returns in U.S. business cycle phases

22

Effect of US Equity Returns on Global Equity ReturnsJanuary 1970 to December 2004

-60%

-40%

-20%

0%

20%

40%

60%

Aust

ralia

Aust

ria

Belg

ium

Cana

da

Denm

ark

Fran

ce

Ger

man

y

Hong

Kon

g

Italy

Japa

n

Neth

erla

nds

Norw

ay

Spai

n

Swed

en

Switz

erla

nd

Unite

d Ki

ngdo

m

Unite

d St

ates

MSC

I THE

WO

RLD

INDE

X

MSC

I EAF

E

MSC

I WO

RLD

ex U

SA

MSC

I Kok

usai

MSC

I PAC

IFIC

MSC

I EUR

OPE

US UpUS Down

Data: Annualized MSCI Monthly Returns in excess of one month T-bill.

23

Effect of US Equity Returns on Global Equity Returns Developed Markets:January 1988 to December 2004

-60%

-40%

-20%

0%

20%

40%

60%

Austr

alia

Austr

ia

Belgi

um

Cana

da

Denm

ark

Finlan

d

Franc

e

Germ

any

Gree

ce

Hong

Kon

g

Irelan

d

Italy

Japa

n

Nethe

rland

s

New

Zeala

nd

Norw

ay

Portu

gal

Singa

pore

Spain

Swed

en

Switz

erlan

d

Unite

d Kin

gdom

Unite

d St

ates

MSCI

THE

WORL

D IND

EX

MSCI

EAFE

MSCI

ACWI

Fre

e

MSCI

World

Free

MSCI

WORL

D ex

USA

MSCI

EAFE

Free

MSCI

Pacifi

c Fre

e

MSCI

Pacifi

c Fre

e ex

Jap

an

MSCI

Koku

sai

MSCI

PACIF

IC

MSCI

EURO

PE

US UpUS Down


24

Effect of US Equity Returns on Global Equity Returns Emerging Markets:January 1988 to December 2004

-60%

-40%

-20%

0%

20%

40%

60%

Arg

entin

a

Bra

zil

Chi

le

Indo

nesi

a

Jord

an

Kor

ea

Mal

aysi

a

Mex

ico

Phili

ppin

es

Taiw

an

Thai

land

Turk

ey

Uni

ted

Stat

es

MSC

I EM

(EM

ERG

ING

MA

RK

ETS)

MSC

I AC

AM

ERIC

AS

MSC

I EM

ASI

A

MSC

I EM

FA

R E

AST

MSC

I EM

LA

TIN

AM

ERIC

A

US UpUS Down


25

Effect of US Equity Returns on Global Equity Returns January 1970 to December 2004

-90%-75%-60%-45%-30%-15%

0%15%30%45%60%75%90%

Aust

ralia

Aust

ria

Belg

ium

Cana

da

Denm

ark

Fran

ce

Ger

man

y

Hong

Kon

g

Italy

Japa

n

Neth

erla

nds

Norw

ay

Spai

n

Swed

en

Switz

erla

nd

Unite

d Ki

ngdo

m

Unite

d St

ates

MSC

I THE

WO

RLD

INDE

X

MSC

I EAF

E

MSC

I WO

RLD

ex U

SA

MSC

I Kok

usai

MSC

I PAC

IFIC

MSC

I EUR

OPE

Quintile 1Quintile 2Quintile 3Quintile 4Quintile 5

Data: MSCI Monthly Returns in excess of one month T-bill. January 1970-December 2004.

26

Effect of US Equity Returns on Global Equity Returns Developed Markets: January 1988 to December 2004

-90%-75%-60%-45%-30%-15%

0%15%30%45%60%75%90%

Austr

alia

Austr

ia

Belgi

um

Cana

da

Denm

ark

Finlan

d

Franc

e

Germ

any

Gree

ce

Hong

Kon

g

Irelan

d

Italy

Japa

n

Nethe

rland

s

New

Zeala

nd

Norw

ay

Portu

gal

Singa

pore

Spain

Swed

en

Switz

erlan

d

Unite

d Kin

gdom

Unite

d St

ates

MSCI

THE

WORL

D IND

EX

MSCI

EAFE

MSCI

ACWI

Fre

e

MSCI

World

Free

MSCI

WORL

D ex

USA

MSCI

EAFE

Free

MSCI

Pacifi

c Fre

e

MSCI

Pacifi

c Fre

e ex

Jap

an

MSCI

Koku

sai

MSCI

PACIF

IC

MSCI

EURO

PE



27

Effect of US Equity Returns on Global Equity Returns Emerging Markets:January 1988 to December 2004

-90%-75%-60%-45%-30%-15%

0%15%30%45%60%75%90%

Arg

entin

a

Bra

zil

Chi

le

Indo

nesi

a

Jord

an

Kor

ea

Mal

aysi

a

Mex

ico

Phili

ppin

es

Taiw

an

Thai

land

Turk

ey

Uni

ted

Stat

es

MSC

I EM

(EM

ERG

ING

MA

RK

ETS)

MSC

I AC

AM

ERIC

AS

MSC

I EM

ASI

A

MSC

I EM

FA

R E

AST

MSC

I EM

LA

TIN

AM

ERIC

A



28

Effect of US Economic Phase on Global Equity ReturnsJanuary 1970 to December 2004

-30%

-20%

-10%

0%

10%

20%

30%

Aust

ralia

Aust

ria

Belg

ium

Cana

da

Denm

ark

Fran

ce

Ger

man

y

Hong

Kon

g

Italy

Japa

n

Neth

erla

nds

Norw

ay

Spai

n

Swed

en

Switz

erla

nd

Unite

d Ki

ngdo

m

Unite

d St

ates

MSC

I THE

WO

RLD

INDE

X

MSC

I EAF

E

MSC

I WO

RLD

ex U

SA

MSC

I Kok

usai

MSC

I PAC

IFIC

MSC

I EUR

OPE

ExpansionRecession

Data: Annualized MSCI Monthly Returns in excess of one month T-bill. NBER dating.

29

Effect of US Economic Phase on Global Equity Returns Developed Markets: January 1988 to December 2004

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

Aust

ralia

Aust

ria

Belg

ium

Cana

da

Denm

ark

Finl

and

Fran

ce

Ger

man

y

Gre

ece

Hong

Kon

g

Irela

nd

Italy

Japa

n

Neth

erla

nds

New

Zea

land

Norw

ay

Port

ugal

Sing

apor

e

Spai

n

Swed

en

Switz

erla

nd

Unite

d K

ingd

om

Unite

d St

ates

MSC

I THE

WO

RLD

IND

EX

MSC

I EA

FE

MSC

I AC

WI F

ree

MSC

I Wor

ld F

ree

MSC

I WO

RLD

ex

USA

MSC

I EA

FE F

ree

MSC

I Pac

ific

Free

MSC

I Pac

ific

Free

ex

Japa

n

MSC

I Kok

usai

MSC

I PA

CIFI

C

MSC

I EU

ROP

E

ExpansionRecession


30

Effect of US Economic Phase on Global Equity Returns Emerging Markets:January 1988 to December 2004

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

Arg

entin

a

Bra

zil

Chi

le

Indo

nesi

a

Jord

an

Kor

ea

Mal

aysi

a

Mex

ico

Phili

ppin

es

Taiw

an

Thai

land

Turk

ey

Uni

ted

Stat

es

MSC

I EM

(EM

ERG

ING

MA

RK

ETS)

MSC

I AC

AM

ERIC

AS

MSC

I EM

ASI

A

MSC

I EM

FA

R E

AST

MSC

I EM

LA

TIN

AM

ERIC

A

ExpansionRecession


31


But we know that the business cycle is to some degree predictable.

• U.S. yield curve predicts business cycle phases– Average returns based on U.S. inverted or normal yield curve– Average returns based on shape of yield curve

32

Yield Curve Inverts Before Last Six Recessions(5-year Treasury note minus 3-month Treasury bill yield)

-6

-4

-2

0

2

4

6

8

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

% Real annual GDP growth

Yield curve

RecessionCorrect 2 Recessions

Correct

RecessionCorrect Yield curve accurate

in recent forecastRecessionCorrect

Annual GDP growthor Yield Curve %

Data though January 2005

Source: Campbell R. Harvey. Update of Harvey (1986, 1988, 1989).

33

Effect of US Yield Curve on Global Equity ReturnsJanuary 1970 to December 2004

-40%

-30%

-20%

-10%

0%

10%

20%

30%

Aust

ralia

Aust

ria

Belg

ium

Cana

da

Denm

ark

Fran

ce

Ger

man

y

Hong

Kon

g

Italy

Japa

n

Neth

erla

nds

Norw

ay

Spai

n

Swed

en

Switz

erla

nd

Unite

d Ki

ngdo

m

Unite

d St

ates

MSC

I THE

WO

RLD

INDE

X

MSC

I EAF

E

MSC

I WO

RLD

ex U

SA

MSC

I Kok

usai

MSC

I PAC

IFIC

MSC

I EUR

OPE

PositiveInverted

Data: Annualized MSCI Monthly Returns in excess of one month T-bill. Yield Curve=10 Year-3 Month Treasuries, one month lagged.

34

Effect of US Yield Curve on Global Equity Returns Emerging Markets:

January 1988 to December 2004

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

Arg

entin

a

Bra

zil

Chi

le

Indo

nesi

a

Jord

an

Kor

ea

Mal

aysi

a

Mex

ico

Phili

ppin

es

Taiw

an

Thai

land

Turk

ey

Uni

ted

Stat

es

MSC

I EM

(EM

ERG

ING

MA

RK

ETS)

MSC

I AC

AM

ERIC

AS

MSC

I EM

ASI

A

MSC

I EM

FA

R E

AST

MSC

I EM

LA

TIN

AM

ERIC

A

PositiveInverted

Data: Annualized MSCI Monthly Returns in excess of one month T-bill. Yield Curve=10 Year-3 Month Treasuries, one month lagged

35

Effect of US Yield Curve on Global Equity ReturnsJanuary 1970 to December 2004

-20%

-10%

0%

10%

20%

30%

40%

Aust

ralia

Aust

ria

Belg

ium

Cana

da

Denm

ark

Fran

ce

Ger

man

y

Hong

Kon

g

Italy

Japa

n

Neth

erla

nds

Norw

ay

Spai

n

Swed

en

Switz

erla

nd

Unite

d Ki

ngdo

m

Unite

d St

ates

MSC

I WO

RLD

INDE

X

MSC

I EAF

E

MSC

I WO

RLD

ex U

SA

MSC

I Kok

usai

MSC

I PAC

IFIC

MSC

I EUR

OPE

InvertedFlatAverageUpwardSteep

Data: Annualized MSCI Monthly Returns in excess of one month T-bill. Yield Curve=10 Year-3 Month Treasuries, one month lagged

36


Conclusions

• For a U.S. investor, the strategic case for international diversification has been oversold

• While tactical opportunities are diminishing through time, there is still plenty of opportunity to enhance portfolio returns by active management using international equities.

Documents

International Diversification: Is It Worth It?